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Turkey’s interest rate policy fuels inflation

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Inflation in Turkey soared last month, with the consumer price index (CPI) rising 36.1% year-on-year (YoY), from 21.3% in November. This sharp rise in inflation is largely attributable to the decision of the Central Bank of Turkey to gradually reduce the interest rate by 5% from September to December, despite fears of a rise in inflation following the high levels of government spending to support the economy during the Covid-19 pandemic. At the end of the third quarter (Q3) of 2021, the policy rate stood at 19%, and it had been lowered to 14% at the end of the fourth quarter (Q4).

Turkey also has a large current account deficit and is highly dependent on foreign capital inflows. The decision by central banks to cut rates has led to a fall in foreign demand for Turkish assets, including the lira, and has exacerbated Turkey’s current currency crisis. Due to this policy, the value of the lira fell by 33.5% quarter-on-quarter (QQ) against the US dollar in the fourth quarter of 2021. On December 20, President Recep Tayyip Erdogan, who influenced the decision of the central banks to cut rates, announced a plan to protect Turkish depositors against the volatility of the lira following the rapid depreciation of the currency in the fourth quarter of 2021. Following this announcement, the lira appreciated by 20, 7% against the US dollar and stabilized around TRY 13.6:1 USD in early January, signaling greater confidence in the currency and stabilization of the economy heading into the new year.

Despite this, President Erdogan remains committed to his policy of lower interest rates despite high and rising inflation, which puts the country at risk of persistent high inflation. Furthermore, President Erdogan’s insistence on having executive power over monetary policy could deter foreign investment on which the Turkish economy depends, increasing the risk of encountering hyperinflation. With the next general elections not scheduled before June 2023, uncertainty surrounding the Turkish economy is therefore likely to persist throughout this year.

The growth of the construction industry in Turkey had already started to slow down in the third quarter of 2021. This can be attributed to inflation in the prices of construction materials, which led to the postponement of major development projects in the country. Overall, the industry grew only 2.7% YoY in 2021 after a 5.5% YoY reduction in 2020, reflecting weak performance compared to previous forecasts. Further rate cuts by the Central Bank of Turkey this year could undermine confidence in the lira and cause building material costs to rise even further, causing the construction sector to grow at a slower pace than expected. At present, the industry is expected to grow by 2.8% this year, but this forecast could be revised downwards if inflation continues to rise with even higher material costs.

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